By Peter Mastrantuono
Investment experts will tell you that the asset allocation decision is the most important investment decision an investor will make. The critical prerequisite to making a smart decision is determining an investor’s personal risk tolerance. This seemingly simple exercise is actually a complicated and consequential decision faced by investors and their financial advisors.
What Advisors Assess to Determine Risk Tolerance
Let’s begin by acknowledging that there is little agreement among regulators, advisors or academics as to how to best assess an investor’s risk tolerance. Nevertheless, financial advisors seek to gain three key insights in gauging an individual’s risk tolerance level.
The first and most common understanding of risk tolerance is an investor’s willingness to take on risk, i.e., is an investor willing to risk a potential decline of X to achieve a potential return of Y?
This is only the start, however, as risk tolerance is multidimensional measure in which a personal disposition toward risk is only one element.
Another way advisors look to determine an investor’s risk tolerance is by assessing an individual’s capacity for risk. Even in cases where two investors may share the same level of willingness to take risk, they may not share the same capacity for risk.
For example, consider two investors, each of whom has indicated a risk tolerance for portfolios that may suffer 25% declines during a bear market. Investor A is age 42, earns $250,000/year and has a portfolio worth of $3 million, while Investor B is age 65, just retired and has a $1.5 million portfolio. Clearly, Investor A has a greater capacity for risk given that he or she remains in his or her prime earning years and seems well ahead of any personal retirement savings goals. Investor B may have a tolerance for higher risk, but he or she has a substantially more limited capacity to weather the downside entailed in that risk.
Another consideration is that risk tolerance can be fluid since investors often anchor their perception of risk to recent events. As investors watch stocks rise to new records amid a long bull market run, they see less risk in stocks. Consequently, they feel more risk tolerant. However, when markets fall their risk tolerance profile can quickly change. It’s why investors exited markets in 2008 and during the March meltdown this year. They redefined their risk tolerance based on current circumstances.
How Advisors Assess Their Clients’ Risk Tolerance
Nearly all advisors will attempt to determine an investor’s risk tolerance through a questionnaire that seeks to understand the issues discussed above. Some of these questionnaires will be sophisticated and lengthy, while others will be short and simple.
Here are some examples of investors risk tolerance questionnaires and how widely they can diverge, even among top financial advice providers: Charles Schwab, Wells Fargo Advisors, Vanguard and Ameriprise.
Questionnaires, however, are really only the start of a conversation. No questionnaire can truly capture an individual’s actual tolerance for risk. That requires sitting down with an experienced financial advisor skilled in evaluating your financial situation, listening to your needs and concerns and adept at understanding the deeper nuances of what you have to say.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.